Deadweight Losses and the Gains from Trade

To gain some intuition for why taxes result in deadweight losses, consider an example. Imagine that |oe cleans lane's house each week for S100. The opportunity cost of Joe's time is $80, and the value of a dean house to Jane is SI20. Thus, loe and lane each receive a $20 benefit from their deal. The total surplus of $40 measures the gains from trade in this particular transaction.

Now suppose that the government levies a $30 tax on the providers of cleaning services. There is now no price that Jane can pay loe thai will leave both of them better off after paying the tax. The most jane would be willing to pay is $120, but then loe would be left with only $70 after paying the tax, which is less than his $80 opportunity cost. Conversely, for Joe to receive his opportunity cost of $80. Jane would need to pay $130, which is above the $120 value she places on a clean house. As a result, lane and Joe cancel their arrangement. Joe goes without the income, and lane lives in a dirtier house.

The tax has made Joe and Jane worse off by a total of $40 because they have each lost $20 of surplus. But note that the government collects no revenue from Joe and Jane because they decide to cancel their arrangement. The $40 is pure deadweight loss: It is a loss to buyers and sellers in a market that is not offset by an increase in government revenue. From this example, we can see the ultimate source of deadweight losses: Taxes cause deadweight losses because they prevent buyers and sellers from realizing mine of the gains from trade.

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